01-07-2013, 10:57 PM
No real need for global markets to react as they did to Fed statement on monetary policy
BY
ON STAMMER From: The Australian July 02, 2013 12:00AM
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WHEN the US Federal Reserve made its major statement on monetary policy on June 20, it meant well. But investment markets in the US and around the world quickly sold off and market volatility rose to panic levels.
Here, the sharemarket shed another 5 per cent; yields on 10-year bonds, which two months ago had been 3 per cent, briefly topped 4 per cent; and the dollar slid further.
Investment markets misunderstood, and overreacted to, the Fed's announcement. Why did this happen, and what are the lessons for investors?
The recent statement on US monetary policy was intended to inform the American (and global) public that the US economic recovery is at a stage where the Fed will soon consider winding back (tapering is the preferred phrase) its quantitative easing program or QE.
The Fed is currently buying $US85 billion a month of government bonds and mortgage credits from the US fixed-interest markets. It's paying with newly printed money (by way of an increase in the deposits US banks hold with the Fed).
Specifically, the Fed indicated that if unemployment falls further over coming months it will likely start the taper, and if trend unemployment continues to decline the QE program could end in the middle of next year.
Many investors and commentators rejected - too quickly, in my view - the Fed's update on the US economy, which forecasts growth of 2.3 to 2.6 per cent this year and 3 to 3.4 per cent in 2014.
There's always room for disagreement on the economic outlook, but the prospects the Fed have outlined look achievable for the US, given the revival in housing, the useful recovery in consumer confidence, low inventories and the bonanza in shale oil and shale gas.
In the days following the Fed's announcement, the loudest voices in investment markets were of those investors and commentators who take a negative view on US growth, citing the cuts in government spending, high rates of unemployment and under-employment, and US companies' preference to build up cash holdings rather than increase their capital spending.
Initially, the dominant view of investors was the US shouldn't make any move away from the ultra-easy setting in monetary policy: the US economy would soften; and bond and share prices, which had gained strength from the Fed printing money, would need to move much lower.
Lesson one from the recent turbulence is that, at times of stress, the prevailing sentiment in investment markets can lose all sense of balance.
This time around, several key details of recent announcements by the Fed were largely ignored: the Fed had outlined a tapering, not an early exit, from its program of buying bonds and mortgage debt; the pace of the taper would be reconsidered as new information on the US economy comes to hand; and the key lever of US monetary policy in normal times - the cash rate - is expected to remain close to zero even when QE is finally called off.
As a result, market sentiment turned far too negative following the Fed's June announcement.
Lesson two is that, despite the initial reaction in markets, the Fed's move will not necessarily cause major and sustained sell-offs for both bonds and shares.
It's true that easy liquidity and the hunt for yield had earlier been positive influences on both asset classes. Looking ahead, however, US shares should benefit from increasing earnings as the upswing in the US economy takes hold; and if the US economy doesn't strengthen, the Fed will modify or even reverse course on the taper.
But the US bond market has been given a reminder call that, sooner or later, it will have to adjust to the loss of its keenest buyer, the Fed, which has been purchasing $US1 trillion of bonds and mortgage debt a year.
And the recent turbulence has been a reminder of the risks in the "carry trade", in which many investors borrow mainly short-term money at low interest rates to hold bonds.
There's always a role for bonds in investment portfolios, but bond investors face capital losses as market yields move up; and inflation reduces the real value of conventional bonds.
The observation Vimal Gor of BT Investment Management made when bond yields spiked after the Fed's announcement had merit: "I think bonds are attractive on a short-term view (three months), but I am neutral on a medium-term view (three months to three years) and bearish on a long-term (five year) view."
Third, the intense criticism of the Fed following its outline of a gradual and conditional taper of QE shows how hard it will be for central banks to frame and explain moves to contain money growth when confidence returns and credit resumes flowing.
Yet, as the Bank for International Settlement warned: "Central banks have borrowed the time the private and public sectors need for adjustment, but they cannot substitute for it. As the stimulus is sustained, it magnifies the challenges of normalising monetary policy; it increases financial stability risks; and it worsens the misallocation of capital."
In the medium-term, the global economy seems likely to experience wide cycles - both in economic conditions and inflation.
Don Stammer is an adviser to the Third Link Growth Fund, Altius Asset Management and Philo Capital. The views expressed are his alone.
don.stammer@gmail.com
BY
ON STAMMER From: The Australian July 02, 2013 12:00AMIncrease Text Size
Decrease Text Size
WHEN the US Federal Reserve made its major statement on monetary policy on June 20, it meant well. But investment markets in the US and around the world quickly sold off and market volatility rose to panic levels.
Here, the sharemarket shed another 5 per cent; yields on 10-year bonds, which two months ago had been 3 per cent, briefly topped 4 per cent; and the dollar slid further.
Investment markets misunderstood, and overreacted to, the Fed's announcement. Why did this happen, and what are the lessons for investors?
The recent statement on US monetary policy was intended to inform the American (and global) public that the US economic recovery is at a stage where the Fed will soon consider winding back (tapering is the preferred phrase) its quantitative easing program or QE.
The Fed is currently buying $US85 billion a month of government bonds and mortgage credits from the US fixed-interest markets. It's paying with newly printed money (by way of an increase in the deposits US banks hold with the Fed).
Specifically, the Fed indicated that if unemployment falls further over coming months it will likely start the taper, and if trend unemployment continues to decline the QE program could end in the middle of next year.
Many investors and commentators rejected - too quickly, in my view - the Fed's update on the US economy, which forecasts growth of 2.3 to 2.6 per cent this year and 3 to 3.4 per cent in 2014.
There's always room for disagreement on the economic outlook, but the prospects the Fed have outlined look achievable for the US, given the revival in housing, the useful recovery in consumer confidence, low inventories and the bonanza in shale oil and shale gas.
In the days following the Fed's announcement, the loudest voices in investment markets were of those investors and commentators who take a negative view on US growth, citing the cuts in government spending, high rates of unemployment and under-employment, and US companies' preference to build up cash holdings rather than increase their capital spending.
Initially, the dominant view of investors was the US shouldn't make any move away from the ultra-easy setting in monetary policy: the US economy would soften; and bond and share prices, which had gained strength from the Fed printing money, would need to move much lower.
Lesson one from the recent turbulence is that, at times of stress, the prevailing sentiment in investment markets can lose all sense of balance.
This time around, several key details of recent announcements by the Fed were largely ignored: the Fed had outlined a tapering, not an early exit, from its program of buying bonds and mortgage debt; the pace of the taper would be reconsidered as new information on the US economy comes to hand; and the key lever of US monetary policy in normal times - the cash rate - is expected to remain close to zero even when QE is finally called off.
As a result, market sentiment turned far too negative following the Fed's June announcement.
Lesson two is that, despite the initial reaction in markets, the Fed's move will not necessarily cause major and sustained sell-offs for both bonds and shares.
It's true that easy liquidity and the hunt for yield had earlier been positive influences on both asset classes. Looking ahead, however, US shares should benefit from increasing earnings as the upswing in the US economy takes hold; and if the US economy doesn't strengthen, the Fed will modify or even reverse course on the taper.
But the US bond market has been given a reminder call that, sooner or later, it will have to adjust to the loss of its keenest buyer, the Fed, which has been purchasing $US1 trillion of bonds and mortgage debt a year.
And the recent turbulence has been a reminder of the risks in the "carry trade", in which many investors borrow mainly short-term money at low interest rates to hold bonds.
There's always a role for bonds in investment portfolios, but bond investors face capital losses as market yields move up; and inflation reduces the real value of conventional bonds.
The observation Vimal Gor of BT Investment Management made when bond yields spiked after the Fed's announcement had merit: "I think bonds are attractive on a short-term view (three months), but I am neutral on a medium-term view (three months to three years) and bearish on a long-term (five year) view."
Third, the intense criticism of the Fed following its outline of a gradual and conditional taper of QE shows how hard it will be for central banks to frame and explain moves to contain money growth when confidence returns and credit resumes flowing.
Yet, as the Bank for International Settlement warned: "Central banks have borrowed the time the private and public sectors need for adjustment, but they cannot substitute for it. As the stimulus is sustained, it magnifies the challenges of normalising monetary policy; it increases financial stability risks; and it worsens the misallocation of capital."
In the medium-term, the global economy seems likely to experience wide cycles - both in economic conditions and inflation.
Don Stammer is an adviser to the Third Link Growth Fund, Altius Asset Management and Philo Capital. The views expressed are his alone.
don.stammer@gmail.com